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Taxes, DCF, and Intrinsic Value


jawn619
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I have seen people use operating income - maintenance cap ex as a proxy for what the company earns. How do you guys think about taxes as it accounts to Intrinsic value?

 

Only distributable cash (present and future) counts towards intrinsic value.

 

Taxes owed by the corporation don't count towards distributable cash, obviously.

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Help me understand better. Tell me where I'm going wrong.

Lets say I'm a company and I make per year

 

$1,000,000 in rev

$500,000 in gross profit

$250,000 in operating profit

$200,000 in owners earnings after I subtract what i need for maintenance capex.

 

now as an owner I don't get the $200,000, I get $200,000*(1-tax rate). Say its 30%. Doesn't that means the cash I get out of the business is $140,000? Aren't taxes an expense as well?

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Help me understand better. Tell me where I'm going wrong.

Lets say I'm a company and I make per year

 

$1,000,000 in rev

$500,000 in gross profit

$250,000 in operating profit

$200,000 in owners earnings after I subtract what i need for maintenance capex.

 

now as an owner I don't get the $200,000, I get $200,000*(1-tax rate). Say its 30%. Doesn't that means the cash I get out of the business is $140,000? Aren't taxes an expense as well?

no, you get 200k. Operating earnings is after tax
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Help me understand better. Tell me where I'm going wrong.

Lets say I'm a company and I make per year

 

$1,000,000 in rev

$500,000 in gross profit

$250,000 in operating profit

$200,000 in owners earnings after I subtract what i need for maintenance capex.

 

now as an owner I don't get the $200,000, I get $200,000*(1-tax rate). Say its 30%. Doesn't that means the cash I get out of the business is $140,000? Aren't taxes an expense as well?

no, you get 200k. Operating earnings is after tax

 

How is operating earnings after tax? operating earnings is what you have after you pay for your cost of goods sold and your operating expenses. Don't taxes come after?

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I have seen people use operating income - maintenance cap ex as a proxy for what the company earns. How do you guys think about taxes as it accounts to Intrinsic value?

 

It is inappropriate for most people to use such measures like op income - maintenance capex or Enterprise value. Op income does not include interest expense, which is a real expense. It is an expense which is here to stay unless you can change the capital structure of the company. It is not easily done, and it is only appropriate to look at if you're actually planning to alter the capital structure via a buyout or influencing the board of directors.

 

Taxes are a real expense too. Companies have in the past been able to re-incorporate themselves in countries in lower tax rates, or have international operations which they can use to leverage the dilution of taxes.

 

For everyday investors like the most of us, who do not have the power to enact such changes, it's best not use measures which leave out specific expenses. If you do, then you're making a bet that someone in the near future will attempt such restructuring for you, and that they are also successful. If this does not work out as planned, then the margin of safety would be reduced by using a more aggressive valuation. Attempting to predict such events is beyond the scope of how I invest, but it would indeed be appropriate analysis for a firm intending to acquire / influence a target in such a manner.

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Guest Schwab711

I have seen people use operating income - maintenance cap ex as a proxy for what the company earns. How do you guys think about taxes as it accounts to Intrinsic value?

 

So this is basically the OE that Buffett mentions. I think he only uses pre-tax numbers to normalize since tax rates can be anywhere between 0% - 35% (not strictly). I think it can be assumed that he considers what the long-run tax rate is likely to be on a case-by-case basis. Some larger companies can keep low rates indefinitely where STMP (Stamps.com) has artificially low tax rates for another year or two (meaning P/E is way too high on a normalized basis).

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I have seen people use operating income - maintenance cap ex as a proxy for what the company earns. How do you guys think about taxes as it accounts to Intrinsic value?

 

It is inappropriate for most people to use such measures like op income - maintenance capex or Enterprise value. Op income does not include interest expense, which is a real expense. It is an expense which is here to stay unless you can change the capital structure of the company. It is not easily done, and it is only appropriate to look at if you're actually planning to alter the capital structure via a buyout or influencing the board of directors.

 

Taxes are a real expense too. Companies have in the past been able to re-incorporate themselves in countries in lower tax rates, or have international operations which they can use to leverage the dilution of taxes.

 

For everyday investors like the most of us, who do not have the power to enact such changes, it's best not use measures which leave out specific expenses. If you do, then you're making a bet that someone in the near future will attempt such restructuring for you, and that they are also successful. If this does not work out as planned, then the margin of safety would be reduced by using a more aggressive valuation. Attempting to predict such events is beyond the scope of how I invest, but it would indeed be appropriate analysis for a firm intending to acquire / influence a target in such a manner.

 

Thanks for your points. They make sense, and are directly contradictory to what people like Tobias Carlisle say about using those metrics on purpose to identify companies that would be attractive to activists and acquirers, in books like Deep Value.

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Thanks for your points. They make sense, and are directly contradictory to what people like Tobias Carlisle say about using those metrics on purpose to identify companies that would be attractive to activists and acquirers, in books like Deep Value.

 

There are definitely uses for these metrics. They are appropriate when used in the correct environment and context. Such metrics would be useful for someone internal to the company in an effort to increase ROE, for example. But as Buffett advocates, the path of least resistance is to invest a company which is already well run than to hope for a weaker one to turn around.

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You need to look at these metrics to see the potential changes that can happen to change the firm under study.  These are important considerations for future changes which can change valuation.  Just looking at what a company is doing today is missing a dynamic Marty Whitman calls Asset Conversion an important aspect of investing.  If difference between the value today and the asset conversion value becomes great activists become involved and pressure is put on management to change.  This can occur even with entrenched management as some on this board have been personally involved in.  In most cases companies that are being run efficiently already have fair valuations.

 

Packer

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I still didn't get an answer... When you evaluate the attractiveness on an investment, you want to see what you get vs what you pay. So generally I've been using EBITDA-MCX as "what I get" and using Enterprise value for "what I pay". This differs on a case to case basis (for example if a company is capitalized hugely with debt you have to take in account that the interest charges become a big expense.)

 

I'm asking is it more correct to use EBITDA-MCX then subtract out the tax? Even though taxes vary it is still a real expense. I don't see a lot of people accounting for it when doing DCFs or calculating intrinsic value and was wondering if someone could shed some light onto why.

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I'm asking is it more correct to use EBITDA-MCX then subtract out the tax?

 

It's more correct for you to subtract both interest and taxes. As mentioned in my other reply, EBITDA-MCX without accounting for interest and taxes is only appropriate if you plan on modifying the company's capital structure to remove their debt, and reincorporating the company in another country to remove the tax expense.

 

If you use EBITDA - MCX without being able to perform the needed restructuring, you will be overvaluing the company since the interest and tax expenses still exist. Such a valuation describes an optimal scenario which management may not achieve for you.

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Operating income is after the depreciation and amortization charge, so it doesn't really make sense to subtract cap ex from this. I am thinking you are probably talking about operating cash flows, in which case yes, Operating cash flow - cap ex (and software costs) is free cash flow which is the true measure of the cash earnings of a company. Operating cash flow is after taxes, but make sure to check 'deferred taxes' that can build up, as this is tax owed but not yet paid, so can make a company's cash flow seem higher than it really is.

 

Some like FCF because the income statement is easily massaged by boards, but be careful, while cash flow is harder to falsify than the income statement, it is still possible, as was shown by Enron. I did a blog post about how Enron fabricated cash flows a couple of years ago https://investingsidekick.com/enron-fraud/

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I still didn't get an answer... When you evaluate the attractiveness on an investment, you want to see what you get vs what you pay. So generally I've been using EBITDA-MCX as "what I get" and using Enterprise value for "what I pay". This differs on a case to case basis (for example if a company is capitalized hugely with debt you have to take in account that the interest charges become a big expense.)

 

I'm asking is it more correct to use EBITDA-MCX then subtract out the tax? Even though taxes vary it is still a real expense. I don't see a lot of people accounting for it when doing DCFs or calculating intrinsic value and was wondering if someone could shed some light onto why.

 

Prof. Damodaran (look him up) uses free cash flow to the firm (FCFF) when comparing cash flows to enterprise value (the value of operating assets). When comparing equity value, he uses free cash flow to equity (FCFE) which is basically FCFF less debt service i.e. cash flow available for distribution to shareholders or to repurchase shares.

 

For FCFF, Damodaran uses EBIT * (1-t) less capex less change in working capital. So, to answer your question, I would reduce your cash flow by taxes. If you don't want to use the above formula, you can always use cash taxes paid, which is usually disclosed as a supplement to the cash flow statement.

 

If you forecast FCFF, you can discount those cash flows at the firm's cost of capital to get to an implied enterprise value (then back off debt and add cash to get to equity value). The cost of capital of the firm (discount rate) is where the tax benefit of paying interest gets factored in.  For example, if the firm's cost of debt is 10%, tax rate is 30% and they are levered 40% debt to total capital, the after-tax (effective) cost of debt is 10% * (1 - 30%) = 7%, which would comprise 40% of your total cost of capital.

 

So yeah, not trying to get in the weeds here, but I would incorporate tax expense into your cash flow figure.

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